The entire US auto industry is on cruise control

The Los
Angeles Auto Show kicked off last week, so I headed to the
City of Angels to take the temperature of the car industry.

The LA show is a logical place to do this. It starts the nearly
six-month marathon that is the global car-show extravaganza,
though you could argue that Frankfurt and Toyota got the ball
rolling this year.

Next up is Detroit, then Geneva, then Chicago, and finally New
York.

In recent years, the auto industry has come to recognize the
importance of the tech-car overlap, so the Consumer Electronics
Show in Vegas in January has become a sort of extra auto show.

After the 2009 downturn and the bailouts and bankruptcies of
Chrysler and General Motors, the car-show mood was grim. Before
the downturn, it had been fraught with fear.

LA was frantically trying to recraft itself as being all about
green mobility and the car of the future, while New York always
felt like an afterthought, the finish line of a desperate journey
packed with too many parties and too many positive talking points
in an industry that wasn't thriving. The European car business
was weak, so the shows there lacked élan.

Comeback story

But the recovery of the past five years has changed the mood.
This burst vividly into view last year, when
Detroit and Geneva served up double shot of wow!
Geneva was a supercarpalooza, while Detroit's fireworks started
with the unveiling of the new Ford GT supercar and the looming
announcement of a historic return to racing at the 24 Hours of Le
Mans, 50 years after an epic Ford win.

The 2014-15 show run was going to be tough to top. Even the New
York show, the media equivalent of nursing a hangover, was a
blast. So to its credit, the auto industry swaggered into LA not
with something dramatic up its sleeve but rather with a sense of
restored self-confidence. In 2009-10, the Detroit Big Three — GM,
Ford, Chrysler (now Fiat Chrysler Automobiles) were on their
backs. In 2015, heading into 2016, they're standing proud.

A booming US auto market is making that possible. There's a real
chance that the annual sales pace here for 2015 will mean 18
million cars and trucks will roll off dealers' lots, making this
the best year ever for the US market. Given that LA takes place
so close to the end of the year, there's only a month to go
before the numbers are added up. And when the math wraps, even if
the total isn't 18 million, it should be close.

Selling cars left and
right.Joe Raedle / Getty
Images

Better, the Big Three are moving an epic number of pickups and
SUVs, which means that they're raking in profits. Cheap gas,
flowing credit, and an economy on the brink of full employment
are driving this happy state of affairs.

Confidence restored

Last year, the LA show didn't fully prepare us for the excitement
that we experienced when Detroit rolled around. But I think that
was because the very good year that the industry enjoyed in 2014
— 16.5 million in total new car sales — came amid massive recalls
(as The New York Times pointed out earlier this year) and didn't
really seem, well, real until 2015 got underway. The
"replacement rate" on car sales in the US is about 15 million,
but after the financial crisis it fell to 10 million. That the
industry had crawled back to a million and a half above
the replacement rate might have been sort of shocking in LA last
year.

In LA this year, the confident streak that commenced in early
2015 was cemented. And the market dynamics are currently hard to
question. Gas is likely to stay cheap through the first half of
2016. The Federal Reserve might raise interest rates, but that
won't necessarily tamp down new-car-buying enthusiasm in a US
market where the average vehicle's age is a historically high 11
years. And while a recession isn't out of the question, it would
take a severe one to send millions to the unemployment line.

As a result, the LA show had a fairly strong sales flavor. The
automakers put a lot of cars and trucks on the floor, because in
LA consumers come to show to see cars that might want to buy.
This reminded me of what how the LA show was organized in 2011,
when the market was recovering but far from booming. Then, the
car makers wanted consumers to see plenty of cars, and
they brought them.

That same vibe was present last week — just vastly intensified.

That said, literally everyone in the auto industry has the word
"cyclical business" burned into their consciousness. That's what
the car game is — cyclical. A top means a decline. And if we hit
18 million this year, there will be a strong case made that we've
peaked. Then the down cycle will commence.

No collapse coming

Several executives I spoke with in LA offered different views on
the market's future. All acknowledged that things can't remain
this good forever, although none predicted an imminent collapse.

Some are aware that a correction could happen, but at the current
US sales level, that wouldn't cause major problems. The
temptation is to say that an 18-million 2015 will be followed by
a 19-million 2016 and a 20-million 2017.

But a market surging that high would create a significant
problem: The automakers would have to build more factories to
serve US demand, an expensive proposition that could become a
liability in a downturn. And there's skepticism among analysts
and industry experts that the US market could climb that high,
selling 3 million more cars and trucks than ever before.

Capacity discipline will be
important.REUTERS/ Nacho
Doce

"We would be very guarded about 20 million," said Hans-Werner
Kass, who heads up McKinsey & Co.'s automotive practice, when
I talked to him earlier this year.

However, between a downturn and a continuing boom, there is a
third option: a plateau. The market could settle into a
17-to-18-million patch for years as the backlog of demand is
worked through. By 2018, all the clunkers could be off the road.

So we end up with a peak that morphs into a plateau. This worries
some analysts. Sanford Bernstein's Max Warburton and his team, in
a report titled "Global Autos: US Profitability Has Peaked — The
Process May Be Gradual, But The Only Way Now Is Down" and
published this week, think some inevitable market dynamics are
about to take hold:

We are convinced we will see intensifying competition going
forward. We don't need deterioration in the American economy
for this to happen – the auto industry will simply compete away
part of its profitability even in a stable environment. With
the market highly unlikely to climb much further, OEMs will
need to chase market share if they want to grow. New products
will need to be priced competitively to succeed.

Warburton is concerned that the industry will be compelled to add
capacity, but when I asked GM's product guru, Mark Reuss, about
this, he dismissed the issue.

His comment echoes what I've heard other US auto-company leaders
say. They're going to do whatever they can to avoid adding
capacity, running plants full out on all shifts to build the cars
and trucks American really wants. New capacity is arriving, but
it isn't going to be the Big Three that add it.

As Sanford Bernstein points out, the Big Three retired 2 million
in capacity after the financial crisis. Exactly that much
capacity is set to return, but from Japanese and German
automakers who are going to need to build into demand, if they
don't want to lose market share.

The US auto market's
recovery has been robust since the cash-for-clunkers scrappage
program in 2009.FRED/Business
Insider

Mellow optimism

The industry started to get excited about 2015 a few months back,
when it appeared that the 17-million-plus annual sales pace was
real. Now that 18 million is a strong possibility, relaxation has
set in. With the possible exception of Volkswagen — whose US
business was weak even before the emission-cheating scandal broke
— everyone selling cars in the US is about to have a fantastic
year.

This has given many a deep collective sense of mellow optimism.
Not overconfidence, not underconfidence. Just right, like a jet
airliner humming along at cruising altitude. We're likely to
maintain this mood for another year, and probably the only two
events that could sour it are a spike in gas prices or a
rearrangement of how credit functions.

On the latter, Warburton thinks the industry has cracked a code.
The rebound in SUVs and trucks has kicked up transaction prices
and yielding beefier profits. But with financial terms now
stretched out past the traditional five years for a new car loan,
more expensive vehicles aren't costing buyers more on a monthly
basis.

"It's like the industry has found a magical, too-good-to-true
formula," Sanford Bernstein's team writes. "OEMs can report much
higher revenue per unit (and therefore record revenues) than
before, but consumers don't pay any more than they did
previously. Of course, it's not sustainable in our view."

Sustainable it isn't. But given what I saw and heard in LA, the
magic formula will remain magical, for at least another year.